Tuesday, May 31, 2011

Noting that vital importance of the ongoing work of the FASB and the IASB to develop and improve financial accounting standards, SEC Chair Mary Schapiro praised the FASB and IASB for prioritizing projects in areas most in need of improved global standards, including revenue recognition, leases, financial instruments, and insurance. In remarks at a Financial Accounting Foundation event, Chairman Schapiro also emphasized the importance of accounting standard-setters having an independent source of funding. In a global financial marketplace measured in the hundreds of trillions of dollars, she continued, accounting board standard setters should not have to rely on voluntary contributions.

In addition to the quality of its board and staff, said the SEC Chair, one reason FASB is able to maintain its position as a world leader is the independent and stable funding it has received through the issuer accounting support fee established under Sarbanes-Oxley. But another important standard-setter, the IASB, lacks an independent and assured source of funding, she noted, as the IFRS Foundation has no authority to impose funding requirements. The SEC Chair noted that the threats of interference during the financial crisis serve as a continued reminder of the importance of financial independence for the IFRS Foundation and the IASB.

From her role as a member of the Monitoring Board, Chairman Schapiro knows that the trustees of the IFRS Foundation are working closely with regulators and other public authorities and key stakeholder groups to explore more stable funding mechanisms. Until then, however, funding for the IASB will remain a challenge. The Chair noted that the SEC staff continues to evaluate short-and long-term options for assisting the Foundation.

There has been growing concern over the lack of independent IASB funding. In a 2007 letter to the SEC, then Senate Banking Committee Chair Christopher Dodd (D-Conn) said that the IASB’s lack of an independent funding mechanism was not in the public’s best interest. In a 2008 letter to the IASB oversight body, the International Corporate Governance Network said that establishing a stable, transparent funding framework would significantly reduce the concern that financial pressure could compromise the independence of the IASB’s decision-making and would also ensure that the Board has adequate resources to fulfill its mission.

A senior Financial Services Authority official has examined the European Commission’s proposals to amend the Markets in Financial Instruments Directive (MiFID) and stated the UK position in a number of areas, including high frequency trading, derivatives, and third-party access. In recent remarks, David Lawton, Head of Markets Infrastructure and Policy, said that cross-border investment and market access should be seen as a key enabler for the EU strategy of sustainable and inclusive growth. The MiFID initiative is a serious effort to rethink some major elements of financial regulation, with draft legislation expected this summer.

Access of US and other third-country firms into EU markets is not currently harmonized under MiFID, but instead left to the discretion of Member States subject to the restriction that they do not give third-country firms more favorable treatment than EU firms. The Commission proposes a harmonized regime in MiFID under which third-country investment firms and market operators would be able to access the EU only if their home jurisdictions were assessed to impose equivalent regulation to the EU regime. The access mechanism would initially be applied only for non-retail investors.

The FSA has serious concerns about the introduction of an equivalence mechanism for the access of US and other third- country firms. An equivalence mechanism could significantly reduce the number of third-country investment firms and market operators who currently have access to EU markets, said Mr. Lawton. In addition, determining equivalence jurisdiction by jurisdiction could tie up a significant amount of resources within both the European Securities and Markets Authority and national authorities which would be better deployed focusing on day-to-day regulatory issues.

Also, the establishment of an equivalence mechanism under MiFID could make it more difficult for EU firms and market operators to access US and other third-country markets. Indeed, the FSA believes that efforts to achieve reciprocity on the basis of an equivalence mechanism could damage relations between the EU and other major jurisdictions.

The FSA official said that US and other non-EU firms and market operators should continue to be able to establish investment firms and regulated markets authorized under MiFID by setting up a subsidiary in an EU Member State. At the same time, it should be clarified that Member States should not allow third-country investment firms and market operators to operate in their jurisdiction on a basis which is more favorable than that which applies to MiFID investment firms and that such branches are not entitled to provide services elsewhere in the EU on the basis of a MiFID passport.

The FSA supports the Commission proposal to minimize differing requirements in Member States to improve efficiency when exchanging information with other countries. But Member States and firms should be given sufficient time for implementing the changes and each step towards harmonization must be strongly supported by rigorous cost and benefit analysis.

MiFID currently recognizes three types of organized trading venues: regulated markets, multilateral trading facilities, and systematic internalizers, which are investment firms dealing on their own account on an organized and frequent basis. The Commission proposes that all organized trading occurring outside these venues be brought within a new organized trading facility (OTF). There would be a sub-regime for the trading of standardized derivatives, a Derivatives Trading Venue.

The FSA is concerned that the OTF category will capture forms of trading that are not truly organized or venue-like. A bulletin board, for example, may appear to be like a trading venue, he noted, but a bulletin board is not a system in which trades can be executed or that is governed by a set of trading rules, and should not be caught by venue-like regulation. Moreover, many of the requirements that the Commission indicates might be attached to the OTF category are already requirements under the investment firm regulatory regime, such as the need for appropriate management of conflicts of interest.

Instead, the UK recommends that the Commission retain the current trading venues, but align the organizational requirements for multilateral trading facilities to those of regulated markets in order to address concerns about a level playing field. The FSA supports the creation of a Derivatives Trading Venue in order to deliver on G-20 commitments for the trading of standardized OTC derivatives.

The Commission proposes extending pre- and post-trade transparency requirements to all derivatives and bond markets. On the pre-trade side, market participants on regulated markets , multilateral trading facilities, and the proposed new category of organized trading facilities would be required to quote continuously. For pure OTC trading, quotes would have to be made publicly available when participants were able and willing to quote, and prices would have to be close to the prices of equivalent instruments on an organized venue. On post-trade transparency, market participants would publicly disclose the price and volume of a transaction after it has taken place.

In the FSA’s view, there should be no pre-trade transparency requirements for OTC trading since, in the new regulatory landscape, these markets will by their nature involve sophisticated counterparties trading illiquid and complex instruments. Pre-trade transparency could be seriously disruptive to dealings in these instruments for little benefit.

On the post-trade side, the FSA supports greater transparency for standardized derivatives that are sufficiently liquid, provided that this is delivered in a tailored way which does not damage liquidity. By improving the timely availability of information, reasoned the FSA official, enhanced transparency can improve the price discovery process, make markets more efficient; help investor confidence in the competitiveness of the prices they are quoted, increase liquidity, and aid in the valuation of financial instruments

With regard to best execution, the Commission proposes that execution venues publish data on execution quality in the financial instruments they trade. The FSA believes that execution quality data, published in a standardized form, would facilitate comparisons of execution quality between trading venues. This would help investment firms to select the venues they include in their execution policies and the destination of their orders.

Information that investment firms are likely to be interested in includes price and speed and likelihood of execution. This is the type of information that venues are required to produce in the US under SEC Rule 605, which applies only to trading in shares. The EU should concentrate on execution quality data for liquid shares where there is greatest competition between organized trading venues, noted the FSA official. If the Commission intends to extend the requirement to non-equity instruments, continued the official, it will be important to recognize the differences between different asset classes and conduct a cost benefit analysis with respect to each asset class.

The Commission is proposing to require the authorization of high frequency trading firms above a specified minimum threshold. High frequency trading firms above a certain threshold would also be required to make continuous quotes in the instruments they trade, and platforms would be required to ensure that orders on their markets rest in place for a given period before being cancelled, or, that participants do not submit more than a given ratio of orders to actual trades.

In the view of the FSA, requiring high frequency trading firms that are direct members of a trading venue to be authorized would ensure that these firms are subject to independent regulatory oversight, including transaction reporting requirements if they have non-intermediated, direct access to markets. A ‘cut-down’ set of investment firm requirements should apply to firms that do not have clients.

In addition, MiFID should specify more detailed and robust risk controls that must be put in place by all regulated firms in relation to their automated trading. Such controls must be sufficient for the complexity and volume of the firm’s trading, and must ensure that algorithms are appropriately tested. Similarly, intermediaries that provide sponsored access to automated traders should have thorough controls in place, because activity that takes place under an intermediary’s membership codes is its responsibility. All trading venues should have systems to manage rogue order entry in place, such as appropriate trading suspension mechanisms

The UK does not think a case has been made to mandate the provision of liquidity by high frequency trading firms. Forcing high frequency traders to become market makers may deter them from entering the market altogether, reasoned the FSA, thereby removing the benefits of the liquidity they currently provide voluntarily. It may also create prudential risks for these firms, leaving them exposed to market movements when other participants are at liberty to withdraw.

Similarly, the UK does not believe that the case has been made to require orders to rest on the book for a minimum period of time. Any participant may wish to delete an order quickly for prudential reasons. Forcing participants to remain in the market could damage overall market efficiency and compromise firms’ risk management.

Noting that transaction reporting is a vital tool in maintaining market integrity, the FSA posited that, in principle, the scope of the transaction reporting regime should be aligned with the scope of the Market Abuse Directive. So, for example, if the scope of Market Abuse Directive were to be extended to cover instruments admitted to trading on a multilateral trading facility, then the UK would expect the transaction reporting regime would be set to capture those instruments too. The FSA believes that the existing approach, in which national authorities collect the data, and share it between them as necessary, works well. The additional costs of giving investment firms the possibility of reporting directly to a mechanism at EU level, as the Commission suggests, might largely outweigh the benefits.

Considering scienter pleadings in securities fraud cases holistically as instructed by the Supreme Court’s Matrixx decision, a Sixth Circuit panel ruled that investors adequately stated a strong inference of scienter when viewing the factors holistically. The inference that two senior company officers recklessly disregarded the falsity of their extremely optimistic statements is at least as compelling as their excuse of failed accounting systems, said the appeals panel. Frank, et al. v. Dana Corporation, et al., (CA-6), No. 09-4233, May 25, 2011.

In the past, the Sixth Circuit conducted its scienter analysis in Rule 10b-5 securities fraud actions by sorting through each allegation individually before concluding with a collective approach. However, the panel here declined to follow that approach in light of the Supreme Court’s recent decision in Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011), in which the Court provided a post-Tellabs example of how to consider scienter pleadings holistically in section 10(b) cases.

Writing for the Court in Matrixx, Justice Sotomayor expertly addressed the allegations collectively, did so quickly, and, importantly, did not parse out the allegations for individual analysis. In the view of the panel, this is the only appropriate approach following Tellabs’s mandate to review scienter pleadings based on the collective view of the facts, not the facts individually.

According to the panel, the former method of reviewing each allegation individually before reviewing them holistically risks losing the forest for the trees. Further, after Tellabs, conducting an individual review of myriad allegations is an unnecessary inefficiency.

Monday, May 30, 2011

SEC Chair Mary Schapiro emphasized that the Commission is absolutely committed to seeing if the 500-shareholder limit still makes sense and intends to do a thorough and rigorous analysis of this threshold. In testimony before the House Oversight and Government Reform Committee, she noted that the review will require the gathering of economic data and analysis because the SEC needs to understand the characteristics of these companies and how their shareholders hold, whether in record name or in the name of the beneficial owner. The SEC Chair added that a staff review of the 500-shareholder test is front and center on the Commission’s agenda. The SEC staff is also reviewing the general solicitation ban as part of its overall review of capital formation regulations. Corporation Finance Director Meredith Cross noted that the staff is likely to recommend that the Commission issue a concept release on the general solicitation ban.

Enacted in 1964, Section 12(g) of the Exchange Act requires companies with more than $10 million in assets whose securities are held by more than 500 owners to file annual and other periodic reports with the SEC, which reports are then available to the public through the SEC's EDGAR database. While the $10 million threshold has been incrementally increased over the years from the $1 million level initially set in 1964, the 500 shareholder requirement has never been updated.

In prepared testimony, Chairman Schapiro noted that, shortly after the enactment of Section 12(g), the Commission adopted rules defining the terms held of record and total assets. The definition of “held of record” counts as holders of record only persons identified as owners on records of security holders maintained by the company in accordance with accepted practice. The Chair explained that the Commission used this definition to simplify the process of determining the applicability of Section 12(g) by allowing a company to look to the holders of its securities as shown on records maintained by it or on its behalf, such as records maintained by the company’s transfer agent.

But Chairman Schapiro observed that the securities markets have changed significantly since the enactment of Section 12(g). Also, since the definition of “held of record” was put into place, a fundamental shift has occurred in how securities are held in the United States. Today, the vast majority of securities of public companies are held in nominee or street name. This means that brokers that purchase securities on behalf of investors typically are listed as the holders of record. One broker may own a large position in a company on behalf of thousands of beneficial owners, she noted, but since the shares are all held in street name they are counted as being owned by one holder of record.

In response to concerns from Rep. Pat Meehan (R-PA) about carving sweat equity out of the 500-shareholer count, Corporation Finance Director Meredith Cross noted that, pursuant to an SEC rule adopted in 2007, options granted to employees don’t count towards the 500 shareholder number. In addition, Corp Fin staff have provided relief so that restricted stock units provided to employees do not have to be counted towards the 500 shareholder trigger. The Director said that the review of the Section 12(g) 500 limit will consider the question of whether employees should be counted at all. She also said that the SEC has heard that the 500 limit is an impediment to capital raising. The staff’s review will consider if 500 is the right number and is the counting being done correctly, that is, are the right people being included in the count

Rep. Patrick McHenry (R-NC) asked why there is a class of accredited investors. Director Cross explained that the notion behind the accredited investor, and if you have $1 million net worth you fit in the definition, is that sometime in the early 1980s it was decided that these investors can fend for themselves and do not need the protection of the securities laws, thus allowing them to participate in unregistered private offerings. In response to further comments from Rep. McHenry on the rationale for including accredited investors in the 500 shareholder count, the Director said that the staff, as part of its review, will consider if accredited investors should be eliminated from the count.

Responding to a question from Committee Ranking Member Elijah Cummings (D-MD) on what principles would guide the SEC staff review of the general solicitation ban and the 500-shareholder rule, and what factors would be considered, Director Cross said that, with regard to the 500-shareholder limit, the staff would like to know the investor makeup of these companies, and the characteristics of these companies. For example, whether they are trading in the dark market or are engines of growth in need of capital. It may turn out that different answers are needed for different companies, said the SEC official, such as for companies bumping up against the 500 limit who cannot get additional capital. There may have to be different tests for different types of companies.

With regard to the general solicitation ban, the Director said that the staff will want to be confident that, if the ban is eliminated and private offerings are allowed through publicity and advertising, the group getting sold to is the group that does not need the protection of the federal securities laws and are, in fact, accredited investors. If they don’t need protection, it may make sense to make it easier to reach them.

In offerings that are exempt from registration under Section 5, the extent to which an issuer may communicate publicly depends on the requirements of the exemption upon which the issuer is relying. One of the most commonly-used exemptions is Section 4(2) of the Securities Act, which exempts transactions by an issuer “not involving any public offering.” Currently, an issuer wishing to rely on Section 4(2) or its safe harbor, Rule 506 of Regulation D, is generally subject to a ban on the use of general solicitation or advertising to attract investors for its offering. The ban was designed to ensure that those who would benefit from the safeguards of registration are not solicited in connection with a private offering.

Rep. Trey Gowdy (R-SC) raised the question of whether the general solicitation ban is constitutional. He noted that the ban implicates a fundamental right and so must be under the strictest level of constitutional scrutiny and must be as narrowly drawn as it can be If the SEC concludes that the general solicitation ban does not pass constitutional muster, he added, there is some precedent for the SEC not to enforce the ban. Rather than not enforce the ban in that instance, replied Chairman Schapiro, the SEC would seek to change it. Chairman Schapiro recognized that the ban does limit speech to some extent and that the SEC staff study will be examining that issue, a First Amendment analysis will be part of the study. The issue is whether the protection of investors is appropriately balanced with the need for companies to effectively communicate in order to raise capital.

The hedge fund industry asked the Financial Stability Board to consider the improvements made by hedge fund counterparties to their risk management practices, as well the new regulations adopted since the advent of the financial crisis, as the Board explores regulatory measures for monitoring the shadow banking system and addressing systemic risks posed by shadow banking. In a letter to the Board, the Managed Funds Association said that the activities of hedge funds are unlikely to pose the types of systemic risks or regulatory arbitrage that concerns the Board.

Since the failure of LTCM, noted the letter, there have been significant changes in the market with respect to counterparty risk management. Counterparties now consistently limit the amount of leverage used by hedge funds by requiring the use of collateral to secure financing to hedge funds. Also, as a result of improvements to counterparty risk management best practices, financial institutions today conduct more in-depth due diligence on, and have a much greater degree of transparency with respect to, their hedge fund clients’ overall portfolios. Many of these changes have been brought about by the Counterparty Risk Management Policy Group

In its discussion draft, the Financial Stability Board proposed four approaches for monitoring the shadow banking system. First, the indirect regulation of bank interactions with hedge funds and other shadow banking entities. Second, the direct regulation of hedge funds and other shadow banking entities. Third, the regulation of particular instruments, markets or activities. Fourth, the employment of macro-prudential measures through policies to strengthen market infrastructure.

The MFA believes that the macro-prudential measures approach would be the most proportionate and efficient option since it would allow regulators to monitor the financial system as a whole and manage the systemic risks appropriately. Steps can then be taken at the proper time, when regulators determine that there may be excessive risk to the system as a whole. In this regard, hedge fund managers would provide regulators with relevant information on the funds they manage in order to allow for efficient monitoring, provided that regulators establish appropriate confidentiality protections for sensitive information. Indeed, emphasized the MFA, the Dodd-Frank Act and the EU Alternative Investment Fund Managers Directive already mandate or will mandate such heightened transparency to regulators.

The direct regulation of shadow banking entities would not be appropriate, said the hedge fund group, since such would be inconsistent with the FSB’s proposed definition of “shadow banking system,” which does not identify specific entities but rather points to a collective system. In addition, hedge fund managers and the markets in which they operate are already subject to extensive regulation.

Following the recent enactment of several legislative initiatives, the regulatory supervision of the hedge fund industry has been enhanced in many respects. For example, under the Dodd-Frank Act, hedge fund advisers are required to register with the SEC and are subject to increased regulatory reporting and transparency requirements. In the European Union, hedge fund managers are subject to the AIFM Directive, which requires compulsory authorization and imposes capital, disclosure and reporting obligations. Hong Kong and Singapore (the main locations for hedge fund managers in Asia) have similarly enhanced their regulatory requirements of fund managers.

Similarly, the regulation of particular instruments, markets or activities is not an attractive option. The MFA is concerned that regulation of instruments, markets or activities over and beyond what is already required by the Dodd Frank Act or the EU Markets in Financial Instruments Directive (MiFID) Directive would result in many types of entities being caught in the regulatory net that have nothing to do with the credit intermediation chain. This would result in an excessive regulatory burden placed on the market in a manner which is not proportionate with the perceived risks.

As part of its review, the MFA asked the Board to consider the unique characteristics of hedge funds. Although hedge funds are often characterized as being highly leveraged financial institutions, said the MFA, the fact is that they are significantly less leveraged than other financial market participants. Given the limited leverage and the collateral posted by hedge funds, any losses that hedge funds incur are almost exclusively borne by their investors, not their creditors, counterparties, or the general financial system.

There are generally two sources of funds for a hedge fund, explained the MFA, its investors and its counterparties, typically global banks or broker-dealers. Hedge fund borrowings from counterparties are done almost exclusively on a secured basis, secured by fund assets or posted collateral, which limits the amount of leverage that any fund may obtain. In the United States, Regulations T, U and X with respect to securities, and regulations mandated under the Dodd-Frank Act with respect to derivatives, impose margin or collateral requirements, thereby restricting the amount of credit that a financial institution can extend to counterparties, including hedge funds. Similarly, European proposals with respect to regulation of the derivatives markets also contain provisions that will have the effect of restricting the amount of leverage that can be obtained by derivatives users, including hedge funds

Hedge fund borrowings are thus done almost exclusively on a secured basis. The posting of collateral by hedge funds reduces the credit exposure of counterparty financial institutions to those funds. Consequently, hedge funds are substantially less likely to contribute to systemic risk by causing the failure of a systemically significant counterparty, such as a major bank. Moreover, the MFA noted that hedge funds often diversify their exposures across many counterparties, mitigating the risk that a fund poses to any one counterparty. For example, following the collapse of Lehman Brothers, many large hedge funds increased the number of prime brokers they use, thus reducing their exposure to

While hedge funds may obtain financing on the repo market and use such financing to acquire longer dated assets, conceded the MFA, the significant difference between typical hedge fund repo liabilities and the typical liabilities of structured investment vehicles or mutual funds is that hedge fund liabilities in repo transactions are part of the collateral and margining process. In addition to the overcollateralization by hedge funds that is built into the repo transaction via haircuts or initial margin, observed the MFA, daily mark-to-market margining allows repo buyers to call for additional cash or securities assets from the hedge fund. Thus, if the value of the repo collateral decreases, the repo buyer can make margin calls and the repo seller is required to deliver additional collateral to the repo buyer, thus ensuring that the hedge fund must always have sufficient assets to meet such potential margin calls.

Sunday, May 29, 2011

As the EU implements the Alternative Investment Fund Managers Directive, the hedge fund industry seeks ensure that the regulation of hedge fund and private equity fund managers is accomplished in a way that is consistent with the G-20 commitment to international coordination. In a letter to the European Securities and Markets Authority (ESMA), the Managed Funds Association said that a coordinated approach would be particularly important to global fund managers required to expend significant resources responding to requests for data, as well as to regulators seeking to assess the state of the financial system in a globally integrated marketplace. As the successor to CESR, ESMA is advising the European Commission on the implementation of the Directive, which creates a comprehensive and effective regulatory framework for hedge and private equity fund managers at the EU level.

During 2013 to 2015 there will be a passport for sales of EU alternative investment funds to investors within the EU. For US and other non-EU funds and managers, national private placement regimes will continue to operate. However, noted ESMA Chair Steven Maijoor, for these regimes to be used, appropriate co-operation arrangements will have to be put in place between the EU regulator concerned and the authority of the third country. The Commission has asked ESMA to provide advice on the establishment of these co-operation arrangement. In recent remarks, Chairman Maijoor said it would be more efficient for a single MoU to be negotiated by ESMA rather than obliging the US and other non-EU authorities to have separate discussions with up to 27 different EU regulators.

More granularly, the hedge fund association asked ESMA to consider that the calculation of assets under management pursuant to the Directive should be based on a fund manager’s net assets under management, which best reflects investor capital that is at risk, and not based on gross assets. Net assets, as calculated on an alternative investment fund’s balance sheet and audited annually, are easily verifiable, noted the MFA, while gross assets would be difficult for regulators to define and confusing for fund managers to calculate, which could lead to uncertainty for market participants. In addition, the calculation of assets under management should exclude certain assets that may be invested in a fund alongside investors’ assets, such as the manager’s own funds.

The association also asked ESMA to advise the Commission to calculate assets under management for non-EU fund managers that are regulated in their home jurisdiction by including only the assets of EU-based funds, the assets of non-EU based funds that are beneficially owned by EU investors, and the assets managed out of a place of business in the EU, such as by an EU sub-manager of a non-EU fund manager. The MFA believes that these three asset categories should be the primary focus of EU regulators and, therefore, should be the relevant factor in determining whether a fund manager should be within the scope of the full regulatory framework created by the Directive.

More broadly, continued the MFA, this approach would achieve the G-20 goal of regulating hedge fund and private fund managers in a manner that avoids inconsistent or unnecessary overlapping regulation. The MFA noted that the US has taken a similar approach with respect to registration of foreign private fund advisers under the Dodd-Frank Act.

The Directive defines leverage as any method by which the fund manager increases the exposure of a fund it manages whether through borrowing of cash or securities, or leverage embedded in derivative positions or by any other means. Neither the Directive nor the ESMA Discussion Paper defines the term “exposure” or how fund managers should calculate the exposures of their funds. The MFA urged the Commission to implement a similar approach for fund managers to calculate the exposure of the funds they manage as that used under the UCITS Directive, which provides alternative methods that managers may use for determining the global exposure of their UCITS funds, including any appropriate advanced risk measurement methodology.

According to the MFA, the definition of leverage has significant implications beyond the issue of determining which hedge fund manager will be required to be authorized under the Directive. It will be relevant to a wide range of regulatory considerations, including regulation of OTC derivatives and systemic risk monitoring and regulation.

With respect to hedge funds, leverage is generally obtained from large financial counterparties, including global banks and broker-dealers, that conduct substantial due diligence and engage in ongoing risk monitoring. Also, fund borrowings are done almost exclusively on a secured basis, which limits the amount of leverage that any fund may obtain. In the MFA’s view, this collateral posting reduces the credit exposure of counterparty financial institutions and makes hedge funds substantially less likely to contribute to systemic risk by causing the failure of a systemically important institution, such as a major bank.

Given the limited leverage and the collateral posted by funds, any losses that they incur are almost exclusively borne by their investors, not the general financial system. Thus, the MFA reminded that the leverage profile of an alternative investment fund is very different than that of other types of financial institutions, such as banks or principal dealers.

With that in mind, the MFA urged ESMA and the Commission to consider a number of factors relevant to the calculation of leverage and the extent to which leverage should be regulated. In considering leverage as a contributor to systemic risk, it is important to consider not only the aggregate amount of such leverage but also the sources and terms of such leverage. Debt that is secured, for example, significantly mitigates systemic risk compared to debt that is unsecured.

Also, the degree of an investment fund’s portfolio leverage must be considered in the context of its asset mix, including the liquidity of those assets, the liquidity rights of fund investors, as well as the size and nature of the capital markets in which those assets are transacted. MFA said that off-balance sheet exposures should be considered as part of determining overall leverage. However, the market value or risk of loss must be considered from a risk exposure perspective, as opposed to simply looking at notional values. Additionally, the nature of the instruments in question and risk of loss must be considered. For example, a purchased option has substantially less risk than a sold option.

The hedge fund association supports regulators having information about funds for purposes of systemic risk assessment, provided that sensitive, proprietary information is kept confidential by regulators. In this regard, the MFA urged the Commission to ensure that such confidentiality be maintained. Because a number of regulators around the world request information from fund managers, the MFA encouraged an internationally coordinated approach to such reports, as well as encouraging regulators to consider the extent to which requesting information from the prime brokers and other market participants and utilities used by fund managers may be a more effective way to gather and analyze information.

Moreover, in this area as in others, a coordinated approach would be more valuable to regulators, noted the MFA, since coordinated reports are more likely to produce data that can be compared across jurisdictions and would eliminate double counting of managers of funds, which will be critical to assessing the state of the global financial system.

Saturday, May 28, 2011

A statutory duty imposed on a company to maintain internal accounting controls was enacted to safeguard the assets of the company and, hence, was enacted for the company’s benefit, and not for the benefit of any third party who might deal with the company’s officers and employees, ruled the Singapore Court of Appeal. Thus, the statutory duty to maintain internal controls did not create a common law duty on behalf of a company to an unlimited class of third-party banks. Skandinaviska Enskilda Banken AB (Publ), Singapore Branch v Asia Pacific Breweries (Singapore) Pte Ltd, Civil Appeals Nos 121 and 122, Court of Appeals, May 19, 2011.’

The opinion was delivered by Chief Justice Chan Sek Keong. The Court of Appeal hears appeals against the decisions of High Court Judges in both civil and criminal matters. It became Singapore's final court of appeal in April of 1994 when appeals to the Judicial Committee of the Privy Council were abolished.

Section 199 (2A) of the Singapore Companies Act requires public companies to devise and maintain a system of internal accounting controls sufficient to provide a reasonable assurance that assets are safeguarded against loss from unauthorized use or disposition; and transactions are properly authorized and recorded as necessary to permit the preparation of true and fair profit and loss accounts and balance-sheets and to maintain accountability of assets.

The court said that the company did not assume any responsibility to the bank in relation to the company’s internal controls. The company, reasoned the appeals court, could not have reasonably foreseen that as a consequence of alleged failures in its internal controls, an unknown bank in the unknown future would grant in the company’s name an unauthorized credit facility based on a forged board resolution and false representations from a company finance manager with limited financial authority. The case told a cautionary tale of how foreign banks in their eagerness to secure a banking relationship with the a prominent local blue-chip company failed to exercise due diligence and extended substantial credit facilities to the company relying merely and almost entirely on false representations made by the company’s finance manager at the material time.

SEC accounting staff have proposed a new framework for the gradual implementation of IFRS into the US financial reporting system that blends the existing convergence and endorsement approaches into what the staff calls ``condorsement.’’ The transition to IFRS under the framework would occur on a staggered basis over a number of years and be coordinated with the ongoing standard-setting activities of the IASB. This approach would avoid the costs of a “big-bang” in which U.S. issuers would have to incorporate the entire body of IFRS all at once. It would also limit the occasions in which U.S. issuers would be required to make two accounting changes in relatively quick succession, potentially causing confusion for investors and possibly causing U.S. issuers to incur incremental costs in making major systems changes and retraining personnel twice instead of once. The framework envisions a new role for FASB under which FASB would participate in the process for developing IFRS, rather than serving as the principal body responsible for developing new accounting standards or modifying existing standards under U.S. GAAP.

The staff noted that the SEC has yet to make a decision as to whether and, if so, how, to incorporate IFRS into the financial reporting system for U.S. issuers. The proposed condorsement approach is one possible framework to effect incorporation. Importantly, the SEC Chief Accountant emphasized that any incorporation approach would not, and could not, affect the SEC’s responsibility under the federal securities laws to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation, nor would it dilute the Commission’s ultimate authority to prescribe accounting principles and standards to be followed by U.S. issuers that provide financial information to the SEC and investors.

The framework proposed by the Office of Chief Accountant is predicated on several principles. First, U.S. GAAP would be retained, but FASB would incorporate IFRS into U.S. GAAP over a defined period of time, with a focus on minimizing transition costs, particularly for smaller issuers. Also, FASB would incorporate newly issued or amended IFRSs into U.S. GAAP pursuant to an established endorsement protocol, requiring a change to how FASB currently operates.

The endorsement protocol would provide the SEC and FASB with the ability to modify or supplement IFRS when in the public interest and necessary for the protection of investors. The framework would share many key features of other major jurisdictions’ processes for incorporating IFRSs into their respective national financial reporting frameworks. However, whereas many countries chose to align existing accounting standards with IFRS through a first-time adoption of IFRS and thereafter keep pace with new or amended IFRSs through endorsement procedures, the framework would include a transitional period during which existing differences between IFRS and U.S. GAAP would be eliminated through ongoing FASB standard-setting efforts.

Countries using an IFRS national incorporation process generally can be divided into those that converge local standards with IFRS without a firm commitment to incorporate fully IFRS as issued by the IASB and those that undertake some form of local endorsement. Under the convergence approach, jurisdictions do not adopt IFRS as issued by the IASB or incorporate IFRSs into their accounting standards directly. Instead, these jurisdictions maintain their local standards but make efforts to converge those bodies of standards with IFRS over time. One example of a country using convergence is China, which is moving its standards closer to IFRS without incorporating IFRS fully into its national financial reporting framework.

Although the joint projects between FASB and the IASB are often denominated “convergence,” noted the SEC staff, those projects are different from the convergence approach described here. The FASB-IASB process involves movement by both standard setters toward a new, mutually-acceptable high-quality standard, while the convergence approach involves movement by a country toward existing IFRS.

Under the endorsement approach, jurisdictions incorporate individual IFRSs into their local body of standards. Many of these jurisdictions use stated criteria for endorsement, which are designed to protect stakeholders in these jurisdictions. The degree of deviation from IFRS as issued by the IASB can vary under this approach. A significant number of EU jurisdictions follow the endorsement approach.

The proposed framework would retain a U.S. standard setter and facilitate the transition process by incorporating IFRSs into U.S. GAAP over some defined period of time, such as five to seven years. At the end of this period, a U.S. issuer compliant with U.S. GAAP should also be able to represent that it is compliant with IFRS as issued by the IASB. Incorporation of IFRS through the framework would result in having a single set of high-quality, globally accepted accounting standards, while minimizing both the cost and effort needed to incorporate IFRS into the financial reporting system for U.S. issuers. It also would align the US with other jurisdictions by retaining the national standard setter’s authority to establish accounting standards.

New Role for FASB

The SEC staff believes that it will be important for the US to continue to have an active role in the international accounting arena to assist in the development and promotion of high-quality, globally accepted accounting standards; to be proactive in identifying new and emerging financial reporting issues; and to ensure that U.S. interests are suitably addressed in the development of those standards

The SEC staff believes that FASB would be the existing body best equipped to fulfill this role. For the endorsement aspect of the framework, FASB would continue to participate in the development and improvement of accounting standards. However, the manner of participation as contemplated in the framework would differ considerably from FASB’s current standard-setting role. Most significantly, FASB would participate in the process for developing IFRS, rather than serving as the principal body responsible for developing new accounting standards or modifying existing standards under U.S. GAAP. FASB would play an instrumental role in global standard setting by providing input and support to the IASB in developing and promoting high-quality, globally accepted standards; by advancing the consideration of U.S. perspectives in those standards; and by incorporating those standards, by way of an endorsement process, into U.S. GAAP. Additionally, FASB would become an educational resource for U.S. constituents to facilitate the understanding and proper application of IFRS and promote ongoing improvement in the quality of financial reporting in the United States.

FASB would continue to promulgate U.S. GAAP primarily through its endorsement of standards promulgated by the IASB. Under the framework, the staff feels that, due to FASB’s participation in the IASB’s standard setting process, FASB should be in a position to readily endorse into U.S. GAAP the vast majority of the IASB’s modifications to IFRS.

However, FASB would retain the authority to modify or add to the requirements of the IFRSs incorporated into U.S. GAAP, similar to other jurisdictions, and such U.S.-specific modifications would be subject to an incorporation protocol under which FASB would determine if the IASB’s modification to IFRS, either by means of issuance of a new standard or amendment of an existing standard, met a pre-established threshold incorporating the public interest and investor protection.

If the IASB’s modification reaches that threshold, FASB would incorporate fully the IASB’s adopted standard into U.S. GAAP. But if FASB concludes to the contrary, in incorporating the standard, it would need to determine whether it should modify the requirements of the standard, retain relevant U.S. GAAP, or find an alternative solution. Before making any modifications, FASB could discuss the situation with other national standard setters to understand their perspectives on the issue and the approaches they have taken for endorsement of that standard in their respective jurisdictions.

Specifically, FASB could add disclosure requirements to those specified by IFRS in order to address U.S. circumstances in a manner consistent with IFRS or prescribe which of two or more alternative accounting treatments permitted by IFRS on a particular issue should be adopted by U.S. issuers in order to achieve greater consistency in U.S. practice.

SEC’s Role

Under the proposed framework, the SEC would be actively engaged in the FASB standard-setting process and also with the broader activities of the IASB and its governance bodies. If IFRS is incorporated into the U.S. financial reporting system, the SEC would maintain its oversight over FASB. Obviously, the Commission would have a less direct oversight relationship with the IASB. While the SEC and SEC staff would provide their perspectives to the IASB, regulators in different jurisdictions may have different or conflicting perspectives, thus having the potential to reduce the SEC’s impact on the IASB’s standard setting.

Under the framework, the SEC staff would build upon the relationships currently held with the IASB and its staff to enhance the processes employed in the oversight of international standards development. Further, the SEC Chief Accountant Office would expand its relationships with other securities regulators with respect to interpretations of accounting matters in order to inform the staff on the application of IFRS across different jurisdictions.

Friday, May 27, 2011

New EU legislation designed to regulate derivatives moved a step closer to enactment with a favorable vote by the European Parliament's Economic Affairs Committee. The legislation will now go to the full Parliament for a possible vote in July. The committee's report, drafted by Werner Langen (EPP, DE), is strict regarding exemptions to the derivatives clearing obligation. However, for pension funds there will be a special regime, provided that the national capital requirements provide a guarantee similar to cleared contracts.

The draft legislation, European Markets Infrastructure Regulation (EMIR), on OTC derivatives, central clearing parties and trade repositories aims to bring greater transparency and stability to the OTC derivatives market. Information on OTC derivative contracts would have to be reported to trade repositories and be accessible to supervisory authorities. OTC derivative contracts would need to be cleared through central counterparties, thus reducing counterparty credit risk. Under the new regulatory regime, a key supervisory role is envisaged for the new European Securities and Markets Authority, which will work closely with national supervisory authorities, and have an important role in authorizing new central counterparties.

The Committee rejected suggestions by some EU Member States that all derivatives should be governed by the Regulation. Instead, the rules would apply only to OTC derivatives, as the European Commission proposed and as was agreed to by the G-20. However, to ensure ESMA has the full picture, reporting obligations would apply to all derivatives.

The Regulation would introduce a reporting obligation for OTC derivatives, a clearing obligation for eligible OTC derivatives, common rules for central counterparties, and measures to reduce counterparty credit risk and operational risk, and rules on the establishment of interoperability between central counterparties. Co-operation arrangements between clearing houses, known as interoperability, whereby traders would be allowed to choose where their trades are cleared, are limited to cash securities. A central counterparty has to have functioned in line with the standards for at least three years before it can apply for authorization for interoperability.

The Committee accepted the reasoning that applying clearing obligations retroactively to existing contracts would result in legal difficulties and create major problems for counterparties. Therefore, clearing will only be mandatory from the moment the regulation enters into force. It does, however, provide for the possibility of retroactivity with regard to reporting obligations and asks ESMA to assess how reporting retroactivity could be introduced if the information in question were essential to regulators.

Ultimately, the Regulation will have to be implemented by the Member States. Looking at EMIR, UK Finance Secretary Mark Hoban welcomed the idea that central counterparties should be used to clear certain classes of derivatives. If implemented proportionately, he said, this will reduce the systemic risk presented by the derivatives market. But the Minister emphasized the importance of properly formulating the Regulation and avoiding the creation of unnecessary burdens. His remarks were delivered at the recent Markit conference in London.

Not all derivatives deemed eligible for central clearing will necessarily be suitable for platform trading, he noted. But at the same time it is important that the scope of the Regulation be sufficiently broad. When it comes to deciding which derivatives should be covered by EMIR, he continued, there are two different roads that could be taken. The first road would see all trades covered by this Regulation, regardless of their venue of execution, while the second would see only those derivatives executed outside of an exchange being subject to this legislation.

All the arguments clearly favor the first approach, the Minister noted, because the purpose of clearing derivatives is to reduce systemic risk and it is not obvious why a derivative would need to be cleared if traded off-exchange, but not if traded on an exchange. Also, there is the issue of market distortion. Restricting the scope would create a sizeable regulatory loophole which, if exploited, would lead to damaging asymmetry in the market. He said that the arguments against a broad scope are hard to fathom, and seem to be about preventing competition in clearing.

House bi-partisan legislation (H.R. 1965) would raise the current 500-shareholder threshold for SEC reporting to 2,000, and also raise the deregistration threshold from 300 to 1,200 shareholders. The legislation was introduced by Rep. Jim Himes (D-CT) and Paul Womack (R-AK). Senate companion bi-partisan legislation was introduced earlier by Senator Kay Bailey Hutchison (R-TX) to raise the 500-shareholder threshold for SEC reporting from the current 500 holders to 2000. The bill, S 556, is co-sponsored by Senator Mark Pryor (D-AK). The legislation would also raise the SEC decertification of registration threshold from 300 shareholders to 1200.

The 500-shareholder threshold has not been updated since 1964 despite the fact of changed financial markets and a dramatic expansion in the number of investors. Enacted in 1964, Section 12(g) of the Exchange Act requires companies with more than $10 million in assets whose securities are held by more than 500 owners to file annual and other periodic reports with the SEC, which reports are then available to the public through the SEC's EDGAR database. While the $10 million threshold has been incrementally increased over the years from the $1 million level initially set in 1964, the 500 shareholder of record requirement has never been updated. While the shareholder threshold of 500 at one time may have been an accurate reflection of a public market, commenters, including the American Bankers Association, believe that it no longer is such a reflection given the vast expansion of the number of investors.

The legislative effort to raise the threshold comes against the backdrop of an impending SEC review of the 500-shareholder trigger as part of a larger review of capital formation regulations. In recent testimony before the House Oversight and Government Reform Committee, SEC Chair Mary Schapiro said that both the question of how holders are counted and how many holders should trigger registration need to be examined.

Chairman Schapiro noted that, shortly after the enactment of Section 12(g), the Commission adopted rules defining the terms held of record and total assets. The definition of “held of record” counts as holders of record only persons identified as owners on records of security holders maintained by the company in accordance with accepted practice. The Chair explained that the Commission used this definition to simplify the process of determining the applicability of Section 12(g) by allowing a company to look to the holders of its securities as shown on records maintained by it or on its behalf, such as records maintained by the company’s transfer agent.

But Chairman Schapiro observed that the securities markets have changed significantly since the enactment of Section 12(g). Also, since the definition of “held of record” was put into place, a fundamental shift has occurred in how securities are held in the United States. Today, the vast majority of securities of public companies are held in nominee or street name. This means that the brokers that purchase securities on behalf of investors typically are listed as the holders of record. One broker may own a large position in a company on behalf of thousands of beneficial owners, she noted, but since the shares are all held in street name they are counted as being owned by one holder of record.

According to Chairman Schapiro, for most public companies this shift means that much of their individual shareholder base is not counted under the current definition of held of record. Conversely, the shareholders of most private companies, who generally hold their shares directly, are counted as holders of record under the definition. This has required private companies with more than $10 million in total assets and that cross the 500 record holder threshold, where the number of record holders is actually representative of the number of shareholders, to register and commence reporting. At the same time, it has allowed a number of public companies, many of whom likely have substantially more than 500 shareholders, to stop reporting, or “go dark, because there are fewer than 500 holders of record due to the fact that the public companies’ shares are held in street name.

A company can “go dark,” or terminate the registration of a class of securities under Section 12(g), by certifying to the Commission either that the class of securities is (1) held of record by less than 300 persons or (2) held of record by less than 500 persons where the total assets of the company have not exceeded $10 million on the last day of each of the company’s most recent three fiscal years.

Thursday, May 26, 2011

The Financial Stability Oversight Council’s proposed regulations implementing Dodd-Frank provisions making FOIA applicable to the Council would give the Council virtually unfettered and unreviewable discretion to reject FOIA requests on technical grounds, claimed a non-profit market public interest group. In a letter to the Council, the Better Markets group said that the proposal could undermine both the letter and spirit of FOIA by the imposition of technical hurdles. Further, the proposed regulations would give the Council unacceptable authority to delegate its duties under FOIA to other agencies from which the Council originally obtained the records in its possession.

The group urged that the proposed regulations be changed to prevent the Council from simply ignoring FOIA requests and to require the Council to explain the defects that must be corrected when it determines that a request is materially deficient. The regulations should also ensure that any Council determination is subject to appeal.

The Council’s discretion to delegate the responsibility for responding to other agencies should be eliminated, said the group. The proposed referral authority would deprive FOIA requestors of important information that they are entitled to receive under the law. For example, a failure by the Council to address a systemic risk in the financial markets could only be assessed in light of what the Council knew about the surrounding facts and circumstances. In turn, much of this information would only be available by reviewing the information that was available to the Council as reflected in the records it received from the reporting agency.

As a practical matter, the proposed referral authority would also cause delays in responding to FOIA requests. Further, the FOIA statute provides no basis for allowing an agency to delegate its responsibilities to another agency.

Groups representing consumers and investors urged the House Committee on Financial Services today to oppose draft legislation introduced by Rep. Michael Grimm (R-N.Y.) that would amend the whistleblower provisions of the Dodd-Frank Act to, among other things, require prospective whistleblowers to initially use the company’s internal compliance program before going to the SEC. In a letter to Financial Services Committee Chair Spencer Bachus, the groups said that the legislation would undermine investigations and hamstring the SEC and undo many of the whistleblower protections called for in the Dodd-Frank Act. The letter was signed by 22 organizations, including the Project on Government Oversight (POGO), the Government Accountability Project, Taxpayers Against Fraud, and Americans for Financial Reform (a coalition of more than 250 national and state organizations working together for strong Wall Street reform).

The letter said that the whistleblower programs the Grimm draft seeks to upend are based on America’s most effective anti-corruption statute, the False Claims Act, which has returned more than $27 billion taxpayer dollars since 1987. Under sections 748 and 922 of the Dodd-Frank Act, the CFTC and the SEC can compensate whistleblowers whose disclosures lead to enforcement actions with penalties of $1 million or more. Like the False Claims Act right to file lawsuits on behalf of taxpayers to challenge fraud in government contracts and share the recovery, these programs are designed to allow the enforcement agencies to create partnerships with insiders with critical knowledge of large-scale corporate misconduct to better protect taxpayers.

The groups noted that the draft legislation would tip off lawbreakers by requiring whistleblowers to report internally before going to the SEC or CFTC, and requiring the SEC to provide notification before taking enforcement action based on a whistleblower disclosure. This would permit lawbreaking companies to thwart SEC enforcement actions by intimidating witnesses and destroying or altering evidence. Most companies acting in good faith with strong compliance programs can expect employees to report internally first without such requirements.

The draft would also disqualify many would-be whistleblowers by denying incentives and awards to any whistleblower with a contractual obligation to cause the employer to investigate or respond to the misconduct or violations. This provision would allow employers to deny access to the incentives and awards created by the new law to any and all employees simply by having them sign an employment agreement containing language stating this obligation.

It also would give the SEC and CFTC the ability to claim a whistleblower was culpable and deny an award without any specific criteria or due process for making that determination. The groups also said that the draft would deny anonymity and counsel by prohibiting contingency fee representation of whistleblowers. According to Dodd-Frank, anonymity is only an option if the whistleblower is represented by counsel, and most whistleblowers cannot afford representation unless it is on contingency. Therefore, the groups reasoned that the Grimm draft bill would deny anonymity to nearly all whistleblowers, and severely undermine the efficacy of the program.

In addition, the draft would remove the incentive to inform regulators by eliminating a minimum award requirement and giving the SEC and CFTC the discretion to give whistleblowers nominal awards. The letter said that whistleblowers put their livelihoods at great risk and make enormous personal and financial investments in revealing the wrongdoing to regulators. The incentive to do so must be at least the minimum award of 10 percent already in the law, noted the groups, which is still below the 15 percent minimums which have created adequate incentives for whistleblowers to use the successful False Claims Act and IRS programs.

Even more, the groups believe that the measure would strip protections for whistleblowers facing retaliation for contacting the SEC or CFTC. The Dodd-Frank Act includes protections against retaliation that are consistent with several other laws that protect a host of private sector employees, including those in financial services, manufacturing, and healthcare. The Grimm draft would legalize retaliation whenever a company’s employment agreements, policies, or company manuals bars employees from communicating with the government. In the view of the investor and consumer groups, this would give corporate criminals a blank check to gag employees and eliminate whistleblowers at will.

Finally, the letter to Chairman Bachus points out that the draft would create an accountability loophole by allowing special treatment for self-reporting if a firm does an internal investigation and makes some corrective action once notified by the SEC and CFTC of the whistleblower tip and pending enforcement action. Under the Grimm draft bill, said the groups, this is a complete loophole for lawbreakers. They would be granted special treatment under the law with reduced penalties, as though they had self-reported, just by virtue of conducting an internal investigation and taking appropriate corrective action. Although this subsection comes under the title “Good Faith,” said the groups, the loophole would in fact allow firms with bad faith to whitewash any allegations of misconduct and instantly reduce their liability.

Wednesday, May 25, 2011

The North American Securities Administrators Association (NASAA) has urged the Oregon Supreme Court to reverse a decision by the state’s Court of Appeals which held that reliance forms a necessary element of a fraud claim under Section 59.137 of the Oregon Securities Law. Filing a brief as amicus curiae in support of the State of Oregon’s petition for review, NASAA contended that the ruling in State ex rel. Oregon State Treasurer v. Marsh & McLennan Cos., if allowed to stand, would severely weaken investor protection laws not only in Oregon, but nationwide. In NASAA’s view, the lower court’s holding significantly weakens the deterrent effect of the Oregon anti-fraud statute and creates road blocks that will prevent defrauded investors from seeking restitution. Additionally, NASAA argued, the decision would place Oregon in a minority with only four other states that require a plaintiff to personally rely upon a defendant’s materially false statement or omission, thereby inviting courts in other jurisdictions to erode similar investor protections.

The State of Oregon, acting as plaintiff in the case on behalf of its public employee retirement fund, had alleged that an insurance consulting and brokerage firm had published false and misleading statements on its website and in official documents in order to deceive investors about the firm’s unethical and illegal business practices. Although noting that the statutory text does not contain the word “reliance," the Court of Appeals reasoned that the language nonetheless implies that, in order to prove a violation, a purchaser must demonstrate fraud, deceit, or misleading conduct on the part of the defendant, all of which require reliance. The Court of Appeals also held that the Oregon Securities Law does not contain the presumption of an efficient market so as to relieve an investor of the burden of proving reliance in an action for securities fraud.

NASAA noted that, for years, Oregon has stood with the vast majority of states that do not require an investor to demonstrate reliance under their anti-fraud statutes. NASAA observed that Comment 4 to Section 509(b) of the Uniform Securities Act of 2002 expressly states that the precursor to Section 509(b), the model statute on which the Oregon anti-fraud provisions were based, has been held to require neither causation nor reliance as an element of a private cause of action. Moreover, the small minority of states that have created a reliance requirement have been severely criticized in leading treatises on state securities law for confusing an implicit and an express remedy. Unlike private actions brought under federal Rule 10b-5, which require reliance because the federal courts turned to the common law in creating an implied case of action, private actions brought under state securities laws are based on express causes of action contained in the language of the statutes themselves. Accordingly, the Oregon Court of Appeals erred when it decided to introduce an implicit element into a statute which contains an express cause of action with no such requirement. Moreover, NASAA contended, the Court of Appeals decision was inconsistent with prior interpretations of a similar statute, Section 59.135, which has been consistently held by the Oregon courts not to require reliance.

Even if the Oregon Supreme Court were to affirm the decision to incorporate a reliance requirement into Section 59.137, NASAA argued that the state high court should correct the Court of Appeals’ failure to recognize the longstanding securities law doctrine of “fraud on the market. " This doctrine, NASAA observed, presumes reliance where there exists a large and efficient market of investors relying upon the available information in the market to set the price for the securities. As NASAA believes that the Court of Appeals erred in ignoring this well-settled doctrine, the organization urged the state high court to grant review to correct the mistake.

Since the US is expected to be the first nation to fully implement a comprehensive regulatory regime for the OTC derivatives markets, Congress is becoming increasingly concerned about the global coordination of derivatives regulations to ensure that the U.S. remains competitive in international markets and to achieve the objectives of reform to reduce systemic risk and enhance market stability and transparency. Testifying before the House Commodities and Risk Management subcommittee, CFTC Commissioner Jill Sommers noted that other jurisdictions are not as far along in their reform process, which may harm the global competitiveness of US businesses, and that there are some important substantive differences between derivatives reform in the US and other jurisdictions.

In Europe, legislation on clearing and reporting requirements for OTC derivatives, called the European Market Infrastructure Regulation, or EMIR, may not be finalized until the end of summer. Also, after adopting legislation, EMIR directs authorities to draft technical standards by June 30, 2012. Rules on mandatory trade execution and other provisions that are parallel to provisions in Dodd-Frank are being considered as part of a review of the EU’s Markets in Financial Instruments Directive (MiFID). However, formal legislation has not been proposed. Japan has passed its legislation and plans to implement reform by the end of 2012. Other jurisdictions such as Singapore, Australia, Hong Kong and Korea are also either providing or planning to provide clearing services.

Subcommittee Chair K. Michael Conaway (R-TX) said that ensuring a coordinated, international regulatory approach is crucial to marketplace stakeholders regardless of their respective size or role in the global financial system. By acting well ahead of other nations, he continued, the US needlessly risks creating serious disadvantages to its own markets by failing to understand and prepare for the substance of international proposals that are far behind. Ensuring that U.S. financial markets retain a competitive edge and are able to continue functioning in both an efficient and effective manner is a goal that cannot be ignored. Chairman Conaway emphasized that Congress must ensure that the assorted derivatives regulatory schemes carried out by the federal government work to promote economic growth, competitiveness, and innovation.

Regarding substantive differences, Commissioner Sommers noted that a provision in the EU’s proposed legislation on clearing and reporting of OTC derivatives would explicitly exempt multilateral development banks such as the International Bank for Reconstruction and Development, while such institutions are not exempt under any of the Commission’s proposed rules. Similarly, the EU is considering exempting pension funds from mandatory clearing of their swaps transactions, while Dodd-Frank does not contemplate any such exemption. Ms. Summers is Chair of the CFTC’s Global Markets Advisory Committee.

Differences also remain with respect to rules being considered at the CFTC and in Europe for the mandatory execution of swaps on a trading platform. According to the Commissioner, the CFTC’s proposed rule on swap execution facilities would create an inflexible model whereby all requests for quote must be submitted to, at a minimum, five swap dealers. The more flexible approach being considered in Europe and by the SEC would allow counterparties to submit a request for quote to a single dealer and still satisfy the trade execution requirement. This is another area where there is a potential for regulatory arbitrage, warned the CFTC Commissioner.

In other areas, such as capital and margin requirements for uncleared swaps, exemptions from mandatory clearing for inter-affiliate transactions, and ownership limits on market infrastructure, the extent of regulatory divergence may not be known for some time, she noted, while assuring that staff continues to work closely with international counterparts as rules develop.

There are also differences between the US and Europe in the approach to position limits, cautioned the Commissioner, adding that this is an area requiring that the regulations be harmonized to the maximum extent possible. The CFTC has for years imposed position limits in the agriculture commodity markets, she said, and proposes to impose position limits in the energy and metals markets. Regulators in the EU have historically not used position limits and, even under current proposals, may only mandate position limits in agricultural commodity markets.

Commissioner Sommers is also concerned that marketplace uncertainty is being creating by not addressing the application of Dodd-Frank to foreign entities and foreign transactions. Section 722(d) of Dodd-Frank explicitly states that the Act does not apply to activities outside the US unless those activities have a direct and significant connection with activities in, or effect on, commerce of the US or contravene rules that the Commission may promulgate to prevent evasion of the Dodd Frank Act. The Commission has not issued any formal guidance on what this section means in practice.

In the past, CFTC staff have relied on the assistance of foreign regulators for the supervision of entities located abroad so long as the foreign jurisdiction is found to have a comparable regulatory structure. But the CFTC has not proposed a mechanism to do this with respect to any of the rules being put forth under Dodd Frank which, said the Commissioner, has already created regulatory uncertainty for firms with global operations.

In his testimony, CFTC Commissioner Bart Chilton noted that, while the European legislation that is set forth in the European Markets Infrastructure Report (EMIR) and in the European securities laws (MiFID) are likely to be adopted later this year, thereby putting Europe somewhat behind the U.S. timeframe, this may have little substantive impact in practice since CFTC Chair Gary Gensler has indicated that the Commission will be pursuing a phased implementation in the U.S. In each jurisdiction, he emphasized, the key goal is to meet the end-2012 deadline set by the G-20.

Commission Chilton also noted the CFTC’s unprecedented coordination with European and Asian counterparts on all major issues relating to the implementation of OTC derivatives oversight regulation. While there are differences on some provisions of the respective laws, he said, the level of overall harmonization is substantial. In addition, he believes it to be fortuitous that many jurisdictions are developing regulations contemporaneously since this allows the CFTC to craft corresponding, standardized, conforming, or complementary rules as appropriate.

Draft legislation in the House requiring initial internal reporting to the company by a prospective whistleblower as a condition of eligibility for an award is supported by the Society of Corporate Secretaries and Governance Professionals. In testimony before the House Capital Markets Subcommittee, the Society said that corporate tip lines or hot lines are an integral part of compliance programs, functioning as valuable mechanisms for revealing and remedying securities law violations, and should be the first line for reporting violations and potential violations. Accordingly, persons seeking to be eligible for a whistleblower bounty should be required to first report the information to the company, so long as the company has an effective corporate compliance program.

The draft legislation was introduced by Rep. Michael Grimm (R-NY) and is designed to improve the Dodd-Frank whistleblower provisions to preserve the viability of internal reporting regimes established by Sarbanes-Oxley and to prevent employees who are responsible for wrongful acts from receiving an award from the program.

Recognizing that not all companies have effective compliance programs, the Society allowed that in certain circumstances it may be appropriate for an individual to report first to the SEC. Thus, the Society supports an exception in the draft legislation recognizes that in cases where a whistleblower is not afforded an anonymous internal reporting hotline or anti-whistleblower retaliation protection, it may be necessary for the employee to report directly to the SEC. Specifically, the draft provides an exception from the requirement for internal reporting if a whistleblower alleges, and the SEC determines, that the employer lacks either an anti-retaliation policy or a system of anonymous reporting, or if the SEC determines that internal reporting is not viable for the whistleblower due to alleged misconduct at the highest level of management or bad faith by the company.

The draft legislation provides that in order to be eligible for an award, awhistleblower must report to the SEC not later than 180 days after reporting the information to the employer. The Society supports this provision.

Moreover, the draft would require the SEC to notify any company before commencing an enforcement action unless the Commission determines in the course of a preliminary investigation of the alleged misconduct, not exceeding 30 days, that such notification would jeopardize necessary investigative measures and impede the gathering of relevant facts based on evidence that the alleged misconduct involved the complicity of the highest level management or bad faith by the company. The Society supports this provision in the case where the company has not been notified of the whistleblower tip to the SEC as a result of an allegation that the company has no anonymous reporting mechanism or anti-retaliation policies or that the highest level of management was involved.

The Society also supports a provision in the Grimm legislation clarifying that a company has authority to enforce existing policies that require employees to report violations and potential violations internally. The draft would allow companies to enforce any established employment agreements, workplace policies or codes of conduct against a whistleblower; and any adverse action taken against a whistleblower for any violation of such agreements, policies, or codes will not constitute retaliation for purposes of this provision provided such agreements, policies, or codes are enforced consistently with respect to other employees who are not whistleblowers. This provision would maintain a company’s ability to take the necessary action against employees who fail to report internal violations.

Similarly, the Society supports the draft’s exclusion of any whistleblower that is found civilly liable, or is otherwise determined by the Commission to have committed, facilitated, participated in, or otherwise been complicit in misconductrelated to a violation. The Society believes that individuals who actively participated or facilitated the violation, even if they did not substantially direct,plan or initiate the misconduct, should not be awarded a whistleblower’s bounty.

Finally, the draft legislation would eliminate the minimum award requirement from the Act to give the SEC flexibility to grant no monetary award. The Society supports this provision since it would allow for bounties smaller than 10 percent in cases where the recovery is very large and the award or potential award could create perverse incentives for employees. The Society believes that the SEC should have the discretion to award any amount up to 30 percent given the facts and circumstances of each case.

The SEC has adopted regulations implementing the whistleblower provisions of Dodd-Frank that would incentivize rather than require prospective whistleblowers to use internal company compliance programs. SEC Chair Mary Schapiro said that the final regulations strike the correct balance between encouraging whistleblowers to pursue the route of internal compliance when appropriate, while providing them the option of heading directly to the SEC. This makes sense, she reasoned, because it is the whistleblower who is in the best position to know which route is best to pursue.

Noting that offering financial incentives for whistleblowers to report appropriate concerns to internal company compliance is unprecedented, Chairman Schapiro believes that incentivizing rather than requiring internal reporting is more likely to encourage a strong internal compliance culture. The SEC rules create incentives for people to report misconduct to their employers, she added, but only if those companies have created an environment where employees feel comfortable that management will take them seriously and where they are free from possible retaliation.

Specifically, the regulations lengthen the period of time in which a whistleblower can wait before coming to the SEC, after reporting internally. Now whistleblowers will be able to get credit for the original date they reported to their company so long as they notify the SEC within 120 days. Through this provision, employees would be able to report their information internally first while preserving their place in line for a possible award from the SEC.

Moreover, the regulations clarify that the Commission, when considering the amount of an award, will consider how much a whistleblower has participated in the internal compliance process. Thus, a whistleblower’s voluntary participation in a company’s internal compliance and reporting systems is a factor that can increase the amount of an award, and, conversely, a whistleblower’s interference with internal compliance and reporting is a factor that can decrease the amount of an award.

Perhaps most significantly, the final rules would give credit to a whistleblower whose company passes the information along to the Commission even if the whistleblower does not. According to Chairman Schapiro, this could create an opportunity for a whistleblower to obtain an award through internal reporting where the whistleblower might not otherwise have qualified for an award because the information was not sufficiently specific and credible.

In other areas, the regulations clarify that whistleblower protections apply to anyone who provides information even if that information relates to a possible securities law violation, and regardless of whether it leads to a successful enforcement action. Agreeing with advocates of a more streamlined procedure for submitting information, the final regulations include a single form that a whistleblower can submit.

The final rules define a whistleblower as a person who provides information to the SEC relating to a possible violation of the securities laws that has occurred, is ongoing or is about to occur. Original information must be based upon the whistleblower’s independent knowledge or independent analysis, not already known to the Commission and not derived exclusively from certain public sources.

Persons who would generally not be considered for whistleblower awards under the regulations include people who have a pre-existing legal or contractual duty to report their information to the SEC, attorneys who attempt to use information obtained from client engagements to make whistleblower claims for themselves unless disclosure of the information is permitted under SEC rules or state bar rules, people who obtain the information by means or in a manner that is determined by a federal court to violate federal or state criminal law, foreign government officials, and officers and directors who are informed by another person of allegations of misconduct, or who learn the information in connection with the company’s processes for identifying, reporting and addressing possible violations of law, such as through the company hotline.

Also not to be considered for whistleblower awards are compliance and internal audit personnel and public accountants working on SEC engagements, if the information relates to violations by the engagement client. However, compliance and internal audit personnel as well as public accountants could become whistleblowers when the whistleblower believes disclosure may prevent substantial injury to the financialinterest or property of the entity or investors, the whistleblower believes that the entity is engaging in conduct that will impede an investigation, at least 120 days have elapsed since the whistleblower reported the information to his or her supervisor or the entity’s audit committee, chief legal officer, chief compliance officer, or at least 120 days have elapsed since the whistleblower received the information, if the whistleblower received it under circumstances indicating that these people are already aware of the information.

Under the rules, a whistleblower who provides information to the Commission is protected from employment retaliation if the whistleblower possesses a reasonable belief that the information he or she is providing relates to a possible securities law violation that has occurred, is ongoing, or is about to occur. In addition, the rules make it unlawful for anyone to interfere with a whistleblower’s efforts to communicate with the SEC, including threatening to enforce a confidentiality agreement.

Tuesday, May 24, 2011

The House Financial Services Committee, chaired by Rep. Spencer Bachus (R-AL), approved legislation giving the SEC and CFTC more time to write and review the Dodd-Frank mandated regulations governing derivatives H.R. 1573, approved by a partisan vote of 30 to 24, addresses concerns that the proposed Dodd-Frank rules governing derivatives could put U.S. firms at a competitive disadvantage to their foreign competitors. The legislation extends the rule writing deadlines on some provisions but leaves the Dodd-Frank Title VII reforms intact. The legislation maintains the current timeframe for defining the key terms as well as the rules requiring reporting of all over-the-counter contracts. Chairman Bachus said that the legislation would give regulators additional time and information to engage in the proper due diligence needed to get the derivatives rules right from the start. H.R. 1573 will provide regulators with vital information about derivatives transactions to ensure transparency and market safety, he emphasized.

During consideration of H.R. 1573, the Committee approved by voice vote an amendment offered by Chairman Bachus to maintain the original Dodd-Frank effective date for the regulators to finish the clearing rules by July 21, 2011. The Committee also approved by voice vote an amendment offered by Capital Markets Subcommittee Chairman Scott Garrett (R-NJ) to change the effective date of the derivatives title to September 30, 2012. An amendment offered by Rep. Stephen Lynch (D-MA) provides that the use of any authority granted to the SEC and CFTC to address speculative trading will not be delayed, including the impact of such trading on the markets, users, or investors and consumers. Also, the Commissions must port to Congress on the use of such authority.

The legislation would add a new section 712(g) to Dodd-Frank requiring the SEC and CFTC before adopting final regulations to conduct public hearings and roundtables and listen to affected market participants, experts and other interested parties. The Commissions must also solicit public comment on the time and resources that would be required of affected parties in order to develop systems and infrastructure necessary, and policies designed, to comply with the proposed regulations and any alternative approaches capable of accomplishing the relevant rulemaking objectives.

Finally, in a nod to international comity, HR 5173 would authorize the SEC and CFTC to exempt non-US persons from the registration and related regulatory requirements of Dodd-Frank to the extent the Commissions determine that the person is subject to a comparable foreign regulatory scheme in its home country and adequate information sharing arrangements are in effect between the SEC or CFTC and the home country regulator. The SEC and CFTC may condition the exemption on compliance with all or any part of the alternate regulatory scheme, and on such other term as the Commission determines appropriate. The SEC and CFTC may also deem any noncompliance with the alternate regulatory scheme a .violation of the corresponding provisions of Dodd-Frank.

The remarks of SEC Commissioner-designate Daniel M. Gallagher at a 2009 PLI seminar should not be construed as either supporting or endorsing the creation of a uniform federal fiduciary standard for brokers and investment advisers. As a senior SEC staffer at the time, he was noting the view of SEC Chair Mary Schapiro’s view that when investors receive similar services from similar financial service providers they should receive the same level of protection regardless of the label applied to that financial service provider.

The House Appropriations Committee released a draft fiscal year 2012 Agriculture Appropriations Act that would set the funding for the CFTC at $171,930,000, including $25,000 for the expense for consultations and meetings hosted by the Commission with foreign governmental and other regulatory officials. That amount is less than the $202 million approved for the CFTC in the 2011FY Continuing Resolution and less than the $308 million in the President’s 2012FY proposed budget. The House Agriculture Subcommittee is expected to mark up the bill this week.

The draft legislation continues the trend of major spending reductions sought by the Republican majority, totaling $17.2 billion in discretionary funding, a cut of over $2.6 billion from last year’s level or over $5 billion below the President’s budget request for these programs. Agriculture Subcommittee Chairman Jack Kingston (R-GA) said that the draft legislation takes spending to below pre-stimulus, pre-bailout levels while ensuring that the CFTC and other agencies are provided the necessary resources to fulfill their duties.

Following up on his earlier letter to FINRA regarding a large hedge fund, Senator Charles Grassley (R-Iowa) asked the SEC to explain how the Commission resolved referrals from FINRA regarding the fund and how the number of referrals over the timeframe in question compares to similarly situated firms. In a letter to SEC Chair Mary Schapiro, the Senator also asked if the SEC ever drafted a Wells Notice with regard to the hedge fund related to any of these referrals or related to any other matter and, if so, to provide a copy of any draft or final Wells Notice. The SEC is asked to respond to these requests by June 7, 2011.

A Wells Notice is an informal procedure used by the SEC to allow persons under investigation for possible securities law violations to present their views to the Commission before an enforcement proceeding is authorized. These presentations are referred to as Wells submissions, after John A. Wells who headed the SEC’s 1972 Advisory Committee on Enforcement Policies and Practices.

In his letter to Chairman Schapiro, Senator Grassley noted his longstanding interest in whether the SEC is properly regulating the financial markets on behalf of pension holders with investments in securities and other investors. Senator Grassley said that he continued this oversight by recently writing to the Financial Industry Regulatory Authority (FINRA) seeking referrals from FINRA from January 1, 2000, to the present regarding the hedge fund, a firm that has been the subject of significant media coverage regarding allegations of insider trading.

While sensitive to the SEC’s concerns about confirming or denying any ongoing investigations, Senator Grassley observed that Congress and the SEC seek information for fundamentally different purposes. Congress conducts fact-finding inquiries in order to shed light on problems and inform potential legislative solutions.

The function of congressional investigations is not to establish whether any private firms have violated the law, he explained, but rather to examine particular facts and circumstances in order to assess how well the SEC and other agencies created by Congress are executing the authorities granted to them. In support of its mission, Congress must sometimes ask questions in the context of specific cases rather than talk about general issues with a federal agency. Indeed, emphasized the Senator, looking into specific examples is essential for Congress to understand how effectively the SEC pursues referrals such as these.

Monday, May 23, 2011

Transparency is at the heart of some of the standards and other projects that the PCAOB is working on in the near term, said PCAOB Member Jay Hanson. In that spirit, he noted that the Board is preparing a concept release to seek public comment on possible changes to the auditor's reporting model with the intention of increasing its transparency and relevance, while not compromising audit quality. In recent remarks, he said that determining how to go about this involves some difficult issues, including balancing the benefits of those potential changes to investors with the potential costs of those changes to the companies and their auditors. In considering these questions, the Board is very interested in the views of management of the companies whose audits will be affected.

These remarks come against the backdrop of recent questioning of the relevance of the outside auditor report on a company’s financial statements, which some commenters have described as a binary boilerplate document with little relevant information for investors and other users of the financial statements. There is a growing consensus that the status quo on audit reports is no longer either appropriate or sustainable.

Board Member Hanson compared a company’s financial statements and annual report to a book report, with many thousands or millions of transactions in a given area summarized into accounts that appear in the financial statements. The footnotes describe some of the accounting policies and details behind the numbers. Management's discussion and analysis explains the numbers and the trends. The financial statements and annual report are sometimes hundreds of pages long, he noted, making for a long and complicated book report.

The auditors carefully review all of this information, conduct certain procedures to test some of the information and underlying assumptions, evaluate the company’s accounting decisions, and issue a report stating simply that the numbers in the financial statements are, or are not, presented fairly in accordance with the relevant accounting standards. The PCAOB has heard that investors are asking for more than this from auditors, and, to some degree, management. This was the conclusion of a report delivered at a recent meeting by a working group of the PCAOB’s Investor Advisory Group. The report found that investors want more information on, among other things, risks, unusual transactions, and the company’s accounting policies. In essence, said Member Hanson, investors want auditors to provide an executive summary of the book report, with further discussion around the question, "How good are the numbers?"

On another area of transparency, Member Hanson said that the Board is deliberating on whether to call on auditors to disclose the location of other firms participating in the audit, which the Board Member called a ``critical piece of information’’, and on which disclosure should come from a variety of angles. This disclosure is important, he explained, because many multi-national companies conduct a significant portion of the audit abroad. While the audit report may be signed by a U.S. auditing firm, he observed, it may be largely based on the work of affiliated firms that are completely separate legal entities in other countries.

More broadly, the Board is concerned about the number of those countries that prohibit the PCAOB from inspecting accounting firms based in their jurisdictions. Until recently, the Board was completely blocked out of the European Union. In January, the Board reached an agreement to conduct inspections in the United Kingdom, and is working with other EU countries on similar agreements. But the Board continues to be blocked from performing inspections of accounting firms in China.

Member Hanson emphasized that the Board is trying hard to ensure that it reach agreements with regulators in those countries to inspect the work of the auditors. In the meantime, the Board believes that more transparency from auditors about what affiliates in what countries were used for the audit, along with an indication of the significance of the work done, will give public companies and investors better information about the degree of PCAOB oversight of the respective firms and audits

Enforcement actions is another area in which the PCAOB is seeking to increase transparency. Currently, the Sarbanes-Oxley Act requires that the Board keep confidential any disciplinary proceedings initiated against CPA firms or individual auditors until those matters have been resolved at the Board level and the respondent firm or auditor has had an opportunity to appeal the Board’s decision to the SEC. This is unlike the practice at the SEC, where enforcement actions against accountants are visible to the public long before they are adjudicated or settled.

The Board has urged Congress to consider changing that. Member Hanson described the road to the enactment of legislation in this area as long and controversial. But the Board will persevere in this goal because, according to Member Hanson, if there is an auditor who the Board thinks is just not doing a good job and not serving investors, it is important that investors have knowledge of the enforcement proceedings against that auditor long before the current rules allow the Board to disclose that information.